BookWatch: Busting myths about Adam Smith, free markets and the invisible hand

BookWatch: Busting myths about Adam Smith, free markets and the invisible hand

What many people think they know about Adam Smith, the 18th century Scottish philosopher known as the father of economics, is often far off the mark.

Contrary to his modern champions on the right and detractors on the left, Smith wasn’t an advocate of cold-blooded self-interest, said Jesse Norman, author of a new biography, “Adam Smith: Father of Economics,” released in the U.S. last week. And while Smith was a firm believer in the power of markets to produce good outcomes, he didn’t espouse the idea that they should be left unfettered and unregulated or that they always produced the optimal result.

Jesse Norman

Norman, a Conservative member of the U.K. Parliament, said in an interview with MarketWatch that Smith saw markets as the product of evolution, shaped by traditions, social norms, trust, the law and government.

‘Thickets of regulation’

In Smith’s time, markets were also often “thickets of regulation” imposed by the state, church, trading guilds and others, Norman said. Smith, indeed argued, that removing undue interference would allow trade to flourish and prosperity to increase.

“But it doesn’t follow from there that he was someone who felt that markets should have no regulation at all,” Norman said. “And that’s important because when you look today at many markets, it becomes clear that a purely laissez faire view, a purely hands-off, let-the-market-do-its-thing view, isn’t going to work.”

The 10-year anniversary over the weekend of the collapse of Lehman Brothers, the pre-eminent marker of the Great Financial Crisis, serves as a reminder.

After all, it was fairly clear that banks were perfectly happy to take on undue risk because they knew they would likely be bailed out. Bonus schemes reflected as much, while taxpayers were left holding the bag when things went wrong.

“Those are not effective markets,” said Norman.

Related: Wall Street pay jumps to highest since financial crisis

Boom and bust

Indeed, as the biography details, Smith lived through a full-blown banking crisis in Scotland, ending with the collapse of the Ayr Bank in 1772. The crisis destroyed much of the value in the Scottish banking system and bore many of the same hallmarks of today’s crises, including a speculative frenzy and complaints that meddling authorities were getting in the way of prosperity by attempting to take away the punch bowl.

“It tells an amazingly contemporary story of boom and bust. And at the end of it, he doesn’t say, well we should take away all the rules and markets should be entirely free,” Norman said.

Indeed, before writing his famous “The Wealth of Nations,” published in 1776, Smith wrote the “Theory of Moral Sentiments,” which is about how moral values and norms are created.

“When you tie the two together, you can see that Smith’s idea of markets isn’t the modern economic idea of disembodied mathematical constructions all working the same way modeled on the foreign exchange market,” Norman said. “It’s much more a social and cultural institution, mediated by values and norms and traditions and practices and the rest of it.”

That’s important, Norman said, because it provides a “moral underpinning to his thinking” and anchors it in trust.

‘Invisible hand’

What then, of the invisible hand, perhaps the most familiar — and most misunderstood — of the concepts popularized by Smith.

In modern economics, the concept of the invisible hand serves as an explanation of the astonishing way that markets, in a completely disaggregated way, can allocate goods efficiently, while generating social value without a central planner.

And Smith does argue that this is the way many markets work. However, he doesn’t think every market works the same way, Norman said.

“He recognizes that some markets can go backwards,” he said. “A famous example would be the slave trade; he doesn’t think that’s a morally beneficent market. He doesn’t think that’s doing anyone any good.”

He’s also familiar with what are now known as Veblen goods, items that see demand increase the more that people pay for them. These are items such as fine art that are more about conspicuous consumption and social display, as opposed to what Norman calls “hamburger and haircut markets,” in which an item or service is bought and then consumed.

Smith also anticipated how markets can get stuck in a rut. In the book, Norman highlights a passage in The Wealth of Nations in which Smith describes a scenario in which the labor market could get stuck in a situation very near what John Maynard Keynes would describe in the 20th Century as a suboptimal equilibrium.

A ‘Smithian narrative’

In the book, Norman attempts to set the record straight on Smith, while arguing that modern economic and social ills could do with a “new Smithian narrative.”

Part of that is thinking about the relationship to social norms and habits — things that can’t really be legislated, Norman said. Indeed, there’s no doubt that over the past several decades, many past norms have eroded, he said.

“In 1970s and into the early ‘80s, the idea that a chief executive of a corporation should earn 500 times the average wage…would have been regarded as outlandish.”

So what would a renewed emphasis on Smithian principles hold?

Norman said that it would broadly amount to a “rediscovery of the political side of political economy. Technically, it pushes you toward a more dynamic understanding of markets than I think you find in economics at the moment.”

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